Rural telephone cooperative's stock-sale gain is patronage-sourced income

Plain-English summary

A taxable rural telephone cooperative had helped form telecommunications companies to obtain lower-cost network resources and better service for its members. Those companies were later combined, and the cooperative sold its stock in the resulting corporation at a gain. Although rural telephone cooperatives are excluded from subchapter T, the IRS applied cooperative tax principles and focused on whether the investment directly facilitated services to patrons. It concluded that owning and selling the stock were directly related to the cooperative's telephone-service purpose, not a passive investment resembling a side business or mutual fund. The gain was therefore patronage-sourced income and could be excluded from the cooperative's gross income for the sale year if properly allocated to its patrons.

Ruling snapshot

• Question: Is the gain from selling stock in a telecommunications company formed to serve the cooperative's members patronage-sourced income?
• Outcome: approved, the gain is patronage-sourced and is excluded if properly allocated to patrons
• Key authorities: IRC §§ 501(c)(12), 1381, 1382, and 1388; Rev. Rul. 69-576; Rev. Rul. 83-135

Full text (IRS public release)

Internal Revenue Service                                      Department of the Treasury
                                                              Washington, DC 20224

Number: 201945011                                             Third Party Communication: None
Release Date: 11/8/2019                                       Date of Communication: Not Applicable
Index Number: 1388.00-00, 1382.00-00
                                                              Person To Contact:
-------------------------                                     -----------------------------, ID No. -------------
-------------------------------                               -----------------
-----------------------------------------------               Telephone Number:
----------------------                                        ----------------------
-------------------------------                               Refer Reply To:
In Re:                                                        CC:PSI:B05
         -----------------------------------------------      PLR-101847-19
                                                              Date:
                                                              August 06, 2019


LEGEND:

COOP                   = ------------------------------------------------------------------------------------------
                         ----------------------
CORP 1                 = -------------------------
CORP 2                 = -----------------------------
CORP 3                 = --------------------------------
Companies              = ------------------------------------------------------------------------------------------
                         -------------------------------------------------------------------------
Year 1                 = -------------------------------------------------------
Year 2                 = -------------------------------------------------------
Year 3                 = -------------------------------------------------------
Year 4                 = -------------------------------------------------------
Year 5                 = -------------------------------------------------------
Year 6                 = -------------------------------------------------------


Dear --------------:

       This letter responds to a request for a private letter ruling, dated January 30,
2019, submitted on behalf of COOP by its authorized representative, regarding the
application of cooperative tax law to the transaction described below.

      COOP is a nonexempt rural cooperative telephone company operating on a
cooperative basis. COOP provides telecommunications and information services on a
cooperative basis to its members. COOP’s members elect a board of directors on a
one-member, one-vote basis. COOP’s bylaws require it to allocate annually patronage
income among its patrons on a patronage basis. COOP was previously granted
exemption as a rural telephone company under section 501(c)(12) of the Internal
Revenue Code, but in recent years COOP is no longer exempt.
PLR-101847-19                               2

       In Year 1, COOP joined with other telephone cooperatives and independent
telephone companies to form CORP 1 to provide an interstate fiber optic network that
provided connectivity to carry voice and data statewide at a lower cost to its members.
In Year 2 and Year 3 COOP joined with some of the same partners to form additional
Companies to procure lower-cost telecommunications resources to serve its members.
In Year 4, to simplify the corporate structure, Companies were combined to form CORP

2. In Year 5, CORP 1 and CORP 2 were combined to form CORP 3 to continue to
provide COOP’s members with telecommunications services.

       In Year 6, COOP sold its stock in CORP 3. COOP’s sale of the stock of CORP 3
will generate gain for COOP. This private letter ruling request concerns the treatment of
the gain realized from the sale of COOP’s stock in CORP 3.

       Section 501(c)(12) of the Code contemplates that rural cooperative telephone
companies may qualify as tax-exempt organizations. As the telephone business has
developed, however, very few rural telephone cooperatives, including COOP, qualify for
this exemption. Therefore, COOP is a non-profit, but taxable, cooperative corporation.

        Subchapter T of the Code, sections 1381-1388, provides the statutory scheme
for taxing most cooperatives. Rural telephone cooperatives, however, are not governed
by subchapter T because of the exclusion provided by section 1381(a)(2)(C) for rural
telephone cooperatives. When Congress enacted subchapter T in 1962, Congress
excluded rural telephone cooperatives to avoid overregulating them and, presumably, to
provide them with more flexible tax treatment because of the necessary services they
provided to underserved parts of the country. The underlying committee reports stated
that cooperative corporations engaged in providing telephone service to persons in rural
areas would continue to be treated the same as under prior law. See H.R. Rep. No.
1447, 87th Cong., 2d Sess. 79, A127 (1962); S. Rep. No. 1881, 87th Cong., 2d Sess.
113, 310 (1962); see also Rev. Rul. 83-135, 1983-2 C.B. 149.

       Sections 1382 and 1388 of subchapter T placed new restrictions on the ability of
cooperatives to deduct patronage dividends that were allocated but not paid. In many
other ways, however, subchapter T codified the law that existed prior to 1962. Since its
enactment in 1962, most of the development in the law regarding the taxation of
cooperatives has occurred in cases under subchapter T. While the cases and rulings
interpreting subchapter T may not control the taxation of rural telephone cooperatives,
these authorities indicate the position of the Service and the courts on many of the
issues that do control the taxation of rural telephone cooperatives.

       Cooperatives are a unique form of business entity, which are democratically
controlled by their patrons. In cooperatives, each member has one vote regardless of
how much capital contributed. Cooperatives are required to allocate their net margins
from business done with or for their patrons back to their patrons in proportion to their
patronage. This return of patronage-sourced income is bound up with the basic concept
of a cooperative. Rather than using their net income to pay dividends to their
PLR-101847-19                                 3

shareholders, as a regular business corporation would, cooperatives pay patronage
dividends to their members based on the amount of business that the member does
with the cooperative. Patronage dividends are thus effectively price rebates for
member-patrons. See CF Industries, Inc. v. Commissioner, 995 F.2d 101, 103 (7th Cir.
1993).

       The taxable income of a cooperative is calculated in much the same manner as
the taxable income of a taxable corporation with one distinct difference: the income of a
cooperative that is attributable to business done with or for patrons is excluded or
deducted from the income of the cooperative when such income is allocated to the
cooperative’s patrons. At the time this patronage-sourced income is allocated (or in the
case of cooperatives not subject to subchapter T, at the time it is distributed) the
cooperative’s patrons realize the income. Patronage-sourced income flows through the
cooperative and is taxed only once.

         For the gain realized by COOP from the sale of its stock in CORP 3 to be
deductible by COOP upon allocation, the amount must be patronage-sourced income,
i.e., income derived from business done with or for COOP’s patrons. While neither the
Code nor the regulations provide a clear definition of patronage-sourced income, the
courts have, in general, held that if the income at issue is produced by a transaction
which is directly related to the cooperative enterprise, such that the transaction
facilitates the cooperative’s marketing, purchasing or service activities, then the income
is deemed to be patronage income. Farmland Industries, Inc. v. Commissioner, 78
T.C.M. 846, 864 (1999), acq., AOD 2001-003 (citing Cotter & Co. v. United States, 765
F.2d 1102, 1106 (Fed. Cir. 1985); Land O’Lakes, Inc. v. United States, 675 F.2d 988,
993 (8th Cir. 1982); Certified Grocers of Cal., Ltd. v. Commissioner, 88 T.C. 238, 243
(1987); Illinois Grain Corp. v. Commissioner, 87 T.C. 435, 459 (1986)).

      In Rev. Rul. 69-576, 1962-2 C.B. 166, the Service provided the following analysis
of what it means for income to be patronage sourced:

       The classification of an item of income as from either patronage or
       nonpatronage sources is dependent on the relationship of the activity
       generating the income to the marketing, purchasing, or service activities of
       the cooperative. If the income is produced by a transaction which actually
       facilitates the accomplishment of the cooperative’s marketing, purchasing,
       or service activities, the income is from patronage sources. However, if
       the transaction producing the income does not actually facilitate the
       accomplishment of these activities but merely enhances the overall
       profitability of the cooperative, being merely incidental to the association's
       cooperative operation, the income is from nonpatronage sources.

See also Rev. Rul. 74-160, 1974-1 C.B. 245 (ruling that interest income realized from
loans made by the taxpayer was patronage source, because the loans “actually
PLR-101847-19                                   4

facilitated the accomplishment of taxpayer’s cooperative activities, in that [the loans]
enabled the taxpayer to obtain necessary supplies for its operations.”)

       Rev. Rul. 83-135, 1983-2 C.B. 149 provides that a taxable cooperative not
subject to the provisions of subchapter T of the Code may exclude from gross income
the patronage dividends paid or allocated to its patrons in accordance with its by-laws.

     COOP owned the stock in CORP 3 to provide better telecommunication services
to COOP’s patrons.

       Courts have ruled in several instances that income from corporations organized
by cooperatives to conduct activities related to the cooperative business is patronage
sourced. In Farmland Industries, the taxpayer, a cooperative organized for the purpose
of providing petroleum products to its patrons, sought to have the proceeds from the
disposition of its stock in three subsidiaries classified as patronage-sourced income. In
reaching its decision, the court stated that its task was to determine whether each of the
gains and losses at issue was realized in a transaction that was directly related to the
cooperative enterprise or in a transaction that generated incidental income that
contributed to the overall profitability of the cooperative, but did not actually facilitate the
accomplishment of the cooperative’s marketing, purchasing, or servicing activities on
behalf of its patrons. 78 T.C.M. at 870.

        Emphasizing the need to focus on the totality of the circumstances and to view
the business environment to which the income producing transaction is related, the Tax
Court analyzed the reasons behind both the organization of the subsidiaries and their
eventual disposition. Id. at 864-65. First, it looked at whether the taxpayer’s
subsidiaries were organized to perform functions related to its cooperative enterprises.
The subsidiaries had been organized to explore for, produce, and transport crude oil.
The Tax Court determined that all of the subsidiaries were organized to perform
functions related to the taxpayer’s business and were not mere passive investments.
Id. at 871.

       In other cases, the direct relationship between the purpose of a cooperative
business and its reasons for investing in a subsidiary were found to be dispositive on
the question of whether income received from the subsidiary was patronage sourced.
For example, in Astoria Plywood Corp. v. United States, 43 A.F.T.R. 2d 79-816, 79-1
USTC ¶ 9197 (D. Or. 1979), the court found that the income derived by a plywood and
veneer workers cooperative from the cancellation of a lease on a veneer plant was
patronage sourced because the production of veneer was an integral part of the
cooperative’s business. In other words, the reason the cooperative leased the property
to begin with had nothing to do with investing in real estate and everything to do with
making veneer. Similarly, in Linnton Plywood Assoc. v. United States, 410 F. Supp.
1100 (D. Or. 1976), the court held that the dividends received by a plywood workers
cooperative from West Coast Adhesives, a glue supplier that the cooperative helped to
organize in order to supply its adhesive needs, were patronage-sourced income
PLR-101847-19                                5

because glue is essential for the manufacture of plywood and because the arrangement
to produce the glue was reasonably related to the business done with or for the
cooperative’s patrons.

       COOP’s ownership of stock in CORP 3 was directly related to COOP’s
cooperative business. Investing in a corporation to provide better telecommunication
service is directly related to the business of a rural cooperative telephone company
whose "reason for existence” is to provide telephone service to its patrons. COOP’s
sale of its stock in CORP 3 is also directly related to COOP’s cooperative business
purpose.

       In CF Industries, Judge Posner noted in his opinion that the court was not aware
of any dramatic opportunities for tax avoidance by use of the cooperative form. 995
F.2d at 104. However, the court implied that a cooperative would be gaining an unfair
tax advantage for its members if it were investing in businesses unrelated to its
cooperative purpose and in effect running a mutual fund for its members on the side.
Id. Judge Posner indicated that one type of transaction would not pass the mutual fund
test: a temporary investment by a cooperative in securities. Id. Certainly, if COOP had
taken its members capital and purchased a diversified portfolio of public company
securities, there can be no doubt that the proceeds from such a portfolio should not and
would not be patronage sourced. But COOP did nothing of this sort. Rather COOP
owned the stock in CORP 3 to provide its patrons with better telecommunication
services.

        Accordingly based on the facts submitted and the representations made, we rule
that:
        The gain from the sale of COOP’s stock in CORP 3 is patronage-sourced income
and, if properly allocated to COOP’s patrons, is excluded from COOP’s gross income in
Year 6.

       Except as expressly provided herein, no opinion is expressed or implied
concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter.

      This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)
provides that it may not be used or cited as precedent.

      The rulings contained in this letter are based upon information and
representations submitted by the taxpayer and accompanied by a penalty of perjury
statement executed by an appropriate party. While this office has not verified any of the
material submitted in support of the request for rulings, it is subject to verification on
examination.
PLR-101847-19                                  6

         In accordance with the Power of Attorney on file with this office, a copy of this
letter is being sent to your authorized representative.

                                                   Sincerely,



                                                   NICOLE R. CIMINO
                                                   Chief, Branch 5
                                                   Office of the Associate Chief Counsel
                                                   (Passthroughs & Special Industries)

Enclosure:
Copy of this letter for § 6110 purposes


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